Trading breakouts is a strategy for getting in on the early stage of a trend. The general principle is to buy when the price breaks high and sell when it breaks low. Within the trading community, breakout trading has mixed reviews. Some believe it’s a reliable strategy with limited downside risk and others believe the risk of false breakouts outweighs the potential benefits.
Generally, a breakout is defined as a price move outside of well-defined levels of support or resistance accompanied by a spike in trading volume. One without the other isn’t a true breakout. Once a breakout is identified, the theory goes, a large price swing and new strong trend will likely follow. The most common price pattern breakouts include the flag, and the range or channel breakout.
The first step is to find a good candidate for breakout trading. Support and resistance should be well tested with multiple touches to establish validity. The longer these levels have remained in place, the more explosive the breakout should be once it occurs and is confirmed.
Timing the entry point is straightforward: Once the price closes above resistance, take a long position. If it closes below support, go short. Again, if there is no accompanying increase in volume, the movement is more likely a fakeout than a breakout, so wait for confirmation by a spike in trading volume before taking a position. It’s always a good idea to set exit points to either take your profit or limit your loss, especially in the face of a failed breakout.
Traders who are skeptical of breakout trading and the risk of false breakouts should avoid the channels and range breakouts and focus more on patterns like the flag or triangle. In day trading, flags and triangles have a better risk to reward ratio and cleaner breakouts. Do be alert to failed breakouts, when a stock retests a prior support or resistance level and falls back through. At this point, you’re best off taking your loss and looking for a better candidate.